Unconstrained fixed income views: February 2026
With signs of improvement in the global manufacturing cycle, we explore whether fiscal easing is starting to pay dividends and consider the disruptive impact on AI on the real economy.
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A lot has happened, yet not a lot has changed. That, in a nutshell, is how we see the world. We leave our scenario probabilities unchanged from last month, continuing to see a low likelihood of the two “tail” outcomes and an even distribution of risks around our central scenarios: “just right” and “warming up”.
No change to the probabilities assigned to our scenarios in February
Source: Schroders Global Unconstrained Fixed Income team, for illustrative purposes only.
The “too cold” scenario would see the Federal Reserve (Fed) cutting 4+ times in 2026, 2-3 cuts for “just right”, while in “warming up” the Fed is only cutting once or is on hold. Finally, in a “too hot” scenario the Fed is moving back towards hikes in 2026, because inflation is becoming problematic again.
Push meets pull
In the US, we think that the strength of January’s non-farm payrolls report likely exaggerated the pace of improvement and we continue to see a shallow recovery for the labour market. Nevertheless, the ongoing reduction in the tail-risk of a negative labour market spiral is an important input for rates market pricing.
Pushing in the other direction, however, the inflation outlook in our view remains benign and generally continues to undershoot consensus expectations. We believe the core drivers of domestic inflation – inflation expectations, wages, productivity, shelter, muted tariff impacts – remain pointing to a favourable disinflationary trend.
This “push and pull” dynamic leaves us in a rangebound environment for US duration (interest rate risk), with an economy that doesn’t clearly need further monetary support but an incoming Fed chair (Kevin Warsh was nominated on 30 January) who is likely to deliver it anyway. This means that there’s also scope for the Treasury yield curve to steepen (where longer maturities underperform shorter maturities).
Talking of growth risks….
A notable development in recent weeks has been the increasing concerns about the disruption impact of AI, especially for software providers after recent updates from Claude and ChatGPT showed increased potential for users to build their own applications.
We recognise this disruptive force as meaningful and see this as creating significant alpha opportunities with regards to credit selection in this sector. However, in our view the likelihood that this spills over into the “real” economy as a negative growth shock is limited, hence our continued low probability on a “too cold” scenario.
Japan shows continued importance of fiscal outlook for financial markets
Another major development was the Japanese election victory on 8 February of Prime Minister Sanae Takaichi on a platform of a less austere and more pro-growth fiscal policy. Since then, she’s sounded more cautious of overdoing it on fiscal expansion, given the high starting point of Japanese government debt.
A prudent fiscal outlook, a central bank likely to tighten monetary policy further and the ongoing improvement in growth is a recipe for a significant flattening of the Japanese yield curve (underperformance of shorter maturities compared to the long end of the yield curve) and a stronger yen.
Europe continues to perform well…and the move to greater defence spending will accelerate
We have been optimistic on the manufacturing cycle for multiple quarters and continue to believe this trend is an upward one. Importantly, it is truly a global move, including the eurozone.
Across the eurozone, we continue to see the inflation outlook as benign with the European Central Bank happily on hold. But with markets now pricing this – having previously priced rate hikes- the gap between our view and the market has lessened, and so we turn neutral on overall eurozone duration.
The combination of a central bank that is on hold, with improving cyclical growth momentum and an ongoing structural shift towards greater defence autonomy should support a steepening of the yield curve.
Continued disinflation in wage dynamics should see the market price in further easing from the Bank of England
We’ve also seen the Bank of England (BoE) turn more dovish in their recent meeting, with a closer vote than expected on rate policy opening the door to a cut in March. Political volatility remains a risk, but we remain positive on gilts as we believe there remains potential (and perhaps growing willingness) for the BoE to ease policy more than the market currently expects.
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